Is there a need for the Fed to raise their policy rate soon?

This post by Nick Rowe on Milton Friedman’s thermostat idea can help us understand why what is often perceived to be loose monetary policy may not actually be so.

See: Why are (almost all) economists unaware of Milton Friedman's thermostat?

Conventional thinking suggest that the when the Fed targets a lower policy rate that their stance is "looser" and when they target a higher policy rate that their stance is "tighter." 

This mistakes the tool, the management of their balance sheet when targeting a policy rate, with the target/policy objective.  If the Fed undershoots their established policy objective, then the policy can be said to have been too tight and vice versa.  More importantly, if market prices imply that the Fed is expected to continue to miss their targets then their current stance is certainly too tight even if their policy rate is sitting on the zero lower bound.      

This chart shows the growth rate in nominal domestic aggregate income.

Without even putting the FF rate on the chart, look at what happened after 2005.  Nominal income growth slowed down.  If the goal was to maintain a constant GDP growth rate, then the Fed’s policy was overly restrictive in accommodating GDP transactions.  Look at what has happened in this recovery. Is the Fed too loose today if the goal is to hit a constant GDP growth rate which is consistent with past expansions?  NO!  The nominal economy has not yet been able to achieve the pace of aggregate income growth that is normally consist with prior expansions.  In other words, the NGDP "speed" has been slower despite the Fed's aggressive "unconventional" (not so unconventional anymore!) central bank policy.  

Now factor in how badly NGDP slowed and fell in each recession.  If the goal is to get to a particular destination by a particular point in time, if the speed slows down at any point it will require that the driver hit a higher subsequent speed to reach the desired destination on time.  In order to recover what was lost in aggregate income after the fall, the Fed should have been doing whatever possible to hit a speed that was higher than before the fall.  This is what is meant by a level or destination target. It requires "catch up" growth/speed after major disruptions which caused the growth path to fall behind.    

Although the Fed doesn't explicitly target aggregate income growth, they have inflation and employment objectives which when taken together work to resemble a NGDP target.  Certain market monetarists suggest that this is an inferior way of conducting monetary policy because inflation is affected by both supply and demand dynamics.  Look at how the oil price drop is impacting inflation measures today as we make year over year comparisons.  If oil prices were to rebound, this will lead to upward pressure on inflation next year even if oil prices are still far below their cyclical or even secular peak from a few years ago.  

As stated in a prior post, it's been argued that inflation in itself is not necessarily a good target unless it is a symptom of economic health that results from sufficient aggregate income growth brought about by increased aggregate demand.  Aggregate demand (sales) is the operative factor, not the inflation rate.  An above target inflation rate is at best a poor indicator of excess aggregate demand especially in the absence of much faster wage growth which would suggest that low long-run unemployment is close by.  That is not the case today unless sub 3% median wage growth and 5.5% unemployment is close enough to force the Fed to react.    

Moreover, if inflation is falling because of greater productive efficiency then this is not necessarily a bad thing at all as long as nominal income growth remains constant or accelerates.  If anything falling prices, in conjunction with a policy that establishes expectations that nominal income growth rates will be constant and high, elevates livings standards as we have more nominal income to purchase an increasing amount of goods and services that the more productive economy is able to produce.    

How is the Fed doing on its inflation objective (2.5% short term, 2% long term) anyways?

In one word... horribly! 

Now my guess is that they are considering a rate rise because they foresee the possibility that future conditions will cause US NGDP to accelerate in the same way a car about to go downhill will.  This will bring their inflation target back to their long and short run objective soon and will require higher policy rates as a result to steady this rise.  If a skilled driver wants to maintain a constant speed, they apply the breaks in anticipation and while going downhill.  This is analogous to the Fed raising the policy rate during a stronger recovery.  If the Fed were to raise the policy rate in this rosy scenario, they wouldn't necessarily be tightening if the growth rate of NGDP was improving enough to accommodate a fully employed economy. 

Here are some takeaways worth considering: 

1.  The reality is that the Fed has missed their inflation target for years while being forced to reduce their assumptions on their long-run unemployment rate.  In light of this, isn't the risk that they will continue to undershoot given their track record?  Furthermore, if overshooting makes up the lost ground due to the policy misses, then is this really such a bad thing?  If you don't think so, then aren't the risks asymmetric where it's preferable to be caution and wait for a period that at least temporarily overshoots before applying the breaks?

2.  Given inflation is falling and NGDP has been growing at a steady pace but one that is much slower than the past expansions and far too slow to make up the ground lost during the recession, does the Fed think that the economy is about to improve that much more quickly going forward?  If not, is starting a rate hike cycle really warranted?  Is US nominal aggregate income growth really too fast especially considering the weak economic data that has come out as of late?  

3.  If the Fed does tighten their policy rate and NGDP slows down, will they admit their forecasting error and retreat?  Does the fall in long term treasury rates and the flattening of the yield curve suggest that market participants think that such a scenario is possible if not likely?  Or is the long end of the treasury yield curve falling due to a scarcity of long term treasury bonds in an environment where stricter bank regulatory requirements are also increasing demand for such safe securities?  What about the rise of the dollar index?  What do these market moves imply about US NGDP growth going forward if anything?     

4.  Why hasn't the Fed been doing whatever it takes to meet the inflation part of the mandate especially considering that NGDP growth is still slower than the past expansions?  This suggests that they have or had room to actually be more expansionary throughout this cycle.  

5.  By not being more expansionary, does the Fed think that monetary policy is already too overextended politically?  Do they believe that monetary policy is either too impotent to do the job or overly risky at this point when considering the potential for future financial instability* associated with the build up of private leverage?  If so, is there room for more expansionary fiscal policy to help maintain NGDP growth while allowing for the non-government sector to reduce leverage below levels considered dangerous by the bubble watchers at the Fed?   

*The fear of future financial instability seems to emanate from the possibility that if the Fed were to wait or are too slow in raising the policy rate that financial excesses will build up to the point where the Fed will be forced to aggressively and abruptly respond in some future period.  Rather than a smooth transition from ZIRP to a more "normal" stance, some Fed officials (Bullard, head of the Reserve Bank of St Louis) are afraid of financial bubbles that would force the Fed to tighten very rapidly to counter such excesses and in doing so would jeopardize the recovery. This speaks to the dangers of a policy stance which is overly dependent on monetary policy that functions by promoting the use of private leverage to facilitate growth in NGDP, employment, and output.    

Then again given that one of the mechanisms which accommodative monetary policy works through is a portfolio rebalancing channel ("search for yield"), it seems a bit incoherent for Fed officials to lament the idea that some asset managers may be taking too much risk in an environment where corporate and dollar denominated foreign bond issuance has expanded massively since the crisis.  Wasn't the point of ZIRP and QE to spur economic activity via an increase in private leverage while macro-prudential tools exist to push against potential financial excesses?  If so, then is the policy rate really the appropriate tool to deal with potential financial extremes if increasing it may cause NGDP and employment growth to slow?  If the Fed does use interest rate policy to stem financial instability concerns, then what does this say about the efficacy of macro-prudential policies?

Finally if the Fed does start a tightening cycle in order to stem the possibility of future financial instability and NGDP growth does end up slowing, couldn't this mix of higher rates and slowing aggregate spending/income growth actually plant the seeds of financial instability?  In other words, could premature tightening bring about the very financial instability conditions which the Fed would be attempting to deter?